The changing dynamics of proprietary trading

Discussion in 'Prop Firms' started by Dogfish, Apr 30, 2013.

  1. Dogfish

    <b>The changing dynamics of proprietary trading</b>
    23 April 2013
    Regulatory changes are forcing firms at every point of the trade cycle to re-evaluate their business models. Proprietary trading houses are no exception, finds Galen Stops.

    Regulatory changes are altering how prop shops do business
    Proprietary trading firms have not been immune to the low volumes and high compliance costs that are blighting much of the industry, and over the past 18 months many have struggled. This has lead to the consolidation within the market.
    Getco buying Automat, Marex Spectron acquiring Schneider Trading Associates and Webb Traders merging with Caerus Trading are all recent examples of this.

    However, with change also comes opportunity for the prop shops. The Volcker Rule in the US and moves to separate proprietary trading divisions from retail banks in Europe will curtail proprietary trading at banks, giving further prominence to traditional prop shops.

    While this will reduce liquidity in the short-term, the talent coming out of the banks will provide significant opportunities for recruitment. But short-term challenges abound for proprietary trading houses. Rising technology costs are hitting margins, while lower volumes are decreasing opportunities for traders.

    At the same time, many traditional point-and-click traders are battling to understand and trade in markets dominated by high-frequency trading.

    Prop houses are innovating to adapt. The changing dynamics of proprietary trading was one of the topics of discussion at FOW’s European Equity Options conference, hosted in Amsterdam on April 9. In particular the panelists discussed how the growing trend of internalising order flow, something that started in the equity markets but is becoming more prevalent in exchange-traded derivatives, is impacting the proprietary trading business.

    Transparency Vs Competition

    Traditionally seen in the larger investment banks, the practice of internalisation is spreading. Internalisation allows a trading desk to match orders in-house, mitigating the exchange fee and therefore offering cheaper trades. In today’s regulatory environment internalisation brings different regulatory objectives into opposition.

    On the one hand, it reduces costs for the end user and provides much needed competition to the exchanges, while on the other it has the potential to drain liquidity out of the established and transparent exchange venues and move it into unregulated and opaque ones, creating “dark pools” of liquidity.

    Mifid I was focused on encouraging competition in the equity markets and as a result liquidity in this market became fragmented as firms were free to set up their own dark pools, broker crossing networks and internalisation facilities.

    The growth in internalised flow can then be directly attributed in large part to Mifid I. But this has dominantly been in equities, which lend themselves more naturally to fragmentation due to the fungibility of stocks. The question now is whether internalisation will expand into exchange traded derivatives markets, which lack fungibility.

    “If you’d asked me six months ago about internalisation I’d have been very confused. But since November our locals outfit has been allowed to trade in dark pools and get their orders filled 35% more,” said Neil Crammond risk manager at London-based proprietary trading firm Futex.

    Crammond said that Futex’s dark pool provider charges 30% less than an exchange to trade and therefore the traders are able to significantly improve their P&L sheets.

    Another fact that some prop houses like about trading in dark pools is that the operator of that pool – unlike an exchange – has discretion over who it allows in to trade in the pool.

    What this means in practice is that a dark pool operator can keep out high frequency trading (HFT) firms, and there are a substantial amount of firms in the market, including most London-based prop shops, for whom a trading environment without HFTs is an attractive prospect.

    “Point-and-click traders have been fighting a battle to keep our Skoda cars up with the HFT Ferraris and perhaps some of the market has voted with dark pools,” said Crammond.

    Internalisation necessary for survival

    In the past, exchanges have traditionally been against internalisation as it reduces their volumes and therefore their revenue. However, one source said that exchanges might consider dark pools might to be a necessary evil that must be tolerated to help keep their liquidity providers in business.

    “From an exchange perspective, while you don’t like the idea of people trading on other platforms or on internalisation engines, what you don’t necessarily see the first time round you might see the second time round because the hedge isn’t there.”

    “Losing prop traders to internalisation platforms is bad, but if it means that it keeps them going for a year or two then that’s good because maybe market conditions will improve and they will be able to continue trading on the exchanges. Obviously not all of their trades will go through internalisation platforms, the majority of their flow will still come to the exchange,” they said.

    In response to the challenge from internalisation, exchange groups could potentially set up similar platforms such as Multilateral Trading Facilities, broker crossing networks or potentially the Organised Trading Facilities being introduced by Mifid II.

    Although such a move would cannibalise some of the volumes on the exchange platform, fragmenting the venue’s own liquidity, it means that the exchange would retain the prop house business rather than losing it to other dark pool providers.

    The definitive Mifid II rules are still not out yet though and it is unclear whether broker crossing networks will be allowed to continue, whether OTFs will replace them and even what an OTF will look like or what the requirements to operate one will be.

    “Essentially the dark pool is a throwback to the floor and therefore the only thing that the exchanges can do to potentially counter them is to play the same game as everyone else and set up a platform that comes under a different regulatory structure,” commented a senior figure speaking under Chatham House Rules.

    The exchange would then argue that they have a broader pool and could offer their customers a single shop dark pool. But realistically, this is not what exchanges want to as it will lead to more fragmentation.

    Hidden liquidity

    Although internalisation currently benefits the prop houses, Crammond argued that it goes against many of the regulatory principles that the governing bodies of the markets are trying to enforce.

    “Maybe we’ll come back in two or three years time and see how much liquidity has been taken away from the market and we’ll be looking at dark pools in a worse light than HFT.

    “I can comfortably see dark pool volumes going up by 25% to 30% in the next 12 to 18 months, and I think that they’re probably more of a threat to the market now than HFTs ever were,” he added.

    One source claimed that the liquidity drain away from the exchanges is already being evidenced, pointing to the fact that compared to five years ago the market depth on a contract like the bund futures has decreased.

    “Now the liquidity is still there, it’s just that you can’t see it and that’s largely because people who used to put orders into market depth don’t put it there anymore and the brokers are trying to out algo the algos.

    “Everyone is drip feeding VWAP, TWAP or other algorithms in and so no one is really certain what’s underneath. There’s probably a lot more liquidity than everyone thinks there is, the difficulty is trying it understand what’s there,” they said.

    There is also a potential danger for operators of internalised engines who could be left holding overnight positions through trade mismatches at the long and short end.

    An example of this is Marex Spectron who acquired Schneider’s and its internal pool linked to the front-end. Traders could conduct a trade a long position in this pool – a bilateral transaction – but then take an equal short position in the afternoon but this time trading through an exchange.

    According to the operator of the internalisation engine the trader’s position is flat, but as far as the exchange is concerned it has only seen one side of the trade so owner of the internalisation engine will have to carry the positions at the exchange until they can net it out against others. This means that the firm, in this case Marex Spectron, has to run the overnight funding of any such mismatch between OTC and ETD trades.

    The new market makers

    As proprietary traders look for new business opportunities resulting from regulatory change, some market participants have questioned whether the prop shops might even replace the banks as market makers.

    Again, regulatory pressure is forcing banks to relinquish this role but currently, proprietary trading houses do not fall under this regulation and therefore could be well placed to be market makers, if they feel that it is an advantage.

    “I’ve noticed on the prop side that 15 or 20 years ago everyone wanted to be a market maker because everything was skewed in your favour, the exchanges gave you breaks and there were good profit margins.

    “Over the past five years this has changed slightly and now I see the exchanges strategically going after these proprietary trading houses for flow. Are the proprietary houses going to replace the market makers?” questioned Gerald Perez, managing director of Interactive Brokers.

    The answer to this question remains unclear for the time being.
  2. Samsara


    Great discussion; thanks for posting this.
  3. This is troubling for the industry. If firms need to make profits by their traders competing for internal liquidity and such it really narrows opportunities. I guess the bottom line is the smaller investors are going to be targeted over the next 2 years. Once those opportunities dry up, we'll see the institutions go into self-destruct mode. It doesn't look pretty going forward.